Backtesting and Paper Trading

Two areas that I am interested in back testing with historical data and also do some paper trading for some time are:

– Investing in penny stocks. Not trading.

– Options and futures and related structures

Successful traders have successful strategies that once start as mere ideas in their heads. While most of the novice traders would dump money on an idea/strategy right upfront, an experienced trader always lets the idea mature and slosh around in his head. He supplants the idea with data validations that come in the form of the two activities listed above.

The process would typically go something like:

Back test → Paper trade → Live trade (small size) → Live trade (full size)

If you cannot back test (lack of data, lack of or lack of access to programming skills, etc.) you should at least paper trade and test drive the strategy. Only after proving the existence of an edge or some type of positive expectancy in your strategy, should one consider moving into live trading with small sizes.

I have just about broken even whenever I have tried to “play” with derivatives. I understand the math a bit but have yet to come to terms with the greeks in live practise. I never did any backtesting or simulated trading before and just took positions based on my gut of where the underlying would go. I guess that is what made the difference for in almost all cases, the underlying did move in the direction I had intended, but I still ended up losing money on most of the trades!

About Kaushal

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